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Chapter 2: The Basics of Supply and Demand

▪ Elasticities of Supply and Demand

o Price elasticity of demand = [% Change in Q] / [% Change in P]

o Price elasticity of demand = [P / Q] * [1 / abs(slope of demand curve)]

o Elasticities pertain to a time frame and can vary between the SR and LR

Chapter 3: Consumer Behavior

▪ Marginal Rate of Substitution (MRS) is the absolute value of the slope of the indifference curve = ratio of the marginal utilities of the two goods (partial derivatives)

▪ A consumer chooses quantities of two goods at the point where an indifference curve is tangent to the budget constraint line

▪ At optimal consumption bundle, MRS = price ratio of two goods (absolute value of the slope of the budget constraint)

▪ MU1 / MU2 = P1 / P2

▪ Cost of living indexes

o CPI is a Laspeyres index – it measures the change in cost for a constant market basket of goods chosen in the base year and thus tends to overstate the rise in prices

o A Paasche index, in contrast, uses a market basket chosen in the present year and calculates the cost of it in the past year thus tending to understate the ideal cost of living adjustment

Chapter 4: Individual and Market Demand

▪ Price-Consumption Curve is the curve traced out by the points representing a consumer’s consumption choices when the price of one good is held fixed and the other good’s price changes

▪ Income-Consumption Curve is analogous to the Price-Consumption Curve except that income varies while prices remain fixed

▪ Normal good = consumption increases as income rises

▪ Inferior good = consumption decreases as income rises

▪ Engel Curve is a plot of Income (vertical axis) vs. quantity of a good consumed (horizontal axis)—useful for identifying normal vs. inferior goods

▪ When the price of one good changes, there is both a substitution and an income effect

o To find the magnitude of the substitution effect, find a hypothetical budget constraint with the new price ratio for the two goods (i.e. parallel to the new budget constraint) but that is tangent to the original indifference curve (from before the price change)

o The income effect is whatever change in consumption is not explained by the substitution effect

o When a large negative income effect outweighs the substitution effect, the good is called a Giffen good

▪ The market demand curve is the horizontal summation of all individual demand curves

▪ Network externality occurs when the quantity of a good demanded by a typical consumer increases (positive—e.g. bandwagon effect) or decreases (negative—e.g. snob effect) in response to the growth in purchases of other consumers

▪ Consumer surplus is the difference between what a consumer is willing to pay for a good and what he actually pays

▪ When demand is price inelastic, an increase in price will lead to an increase in expenditure. When demand is price elastic, an increase in price will lead to a decrease in expenditure

Chapter 5 – Uncertainty and Consumer Behavior

▪ Risk premium – maximum amount of money a person will pay to avoid taking a risk. For a risk averse person, the plot of utility vs income is upward sloping but with diminishing marginal utility. The risk premium is the difference in income between the expected value of a risky proposition and income associated with the point on the indifference curve with the same utility as the expected utility

▪ Risk can be reduced by diversification, insurance, and additional information

▪ Behavioral economics

o Reference points – people dislike losing things that they already possess more than they like gaining things they don’t have

o Fairness – people often forgo consumption when they think prices are “unfair” even though they are within the limits of consumer demand

o Probability – people often misjudge probabilities via the “law of small numbers” which tends to overstate the probability that certain events will occur

Chapter 6 - Production

▪ In the SR one or more inputs are fixed, in the LR all inputs are variable

▪ Law of Diminishing Marginal Returns – as the use of an input increases in equal increments (with other inputs fixed), a point will be reached at which the resulting additions to output decrease

▪ Isoquants are analogous to indifference curves

▪ Marginal Rate of Technical Substitution (MRTS) = - (change in K) / (change in L) for a given level of q or the absolute value of the slope of the isoquant

▪ MRTS = MPL / MPK

▪ Returns to scale

o Increasing returns to scale – output more than doubles when inputs are doubled

o Likewise for constant and decreasing returns to scale

o Returns to scale need not be constant across all levels of output

Chapter 7 – The Cost of Production

▪ Isocost lines are the production equivalent of the consumer’s budget constraint line (TC = wL + rK)

▪ A producer chooses levels of K and L for a given target production quantity by selecting the point on the isocost line that is tangent to the isoquant, at this point:

o MRTS = w /r = MPL / MPK

▪ Expansion path plots the combinations of K and L that a firm will choose to minimize costs at all levels of output

▪ Returns to scale refers only to cases where the ratio of inputs is held constant. When a firm can, for example, double its output for less than double the cost, it is said to enjoy economies of scale (conversely, a firm can suffer from diseconomies of scale)

▪ Economies of scope – a single firm can produce two products more cheaply than two firms each producing one product (also diseconomies of scope)

▪ Learning curve shows how the input needed to produce a given output falls as the cumulative output of the firm increases

Chapter 8 – Profit Maximization and Competitive Supply

▪ Perfect Competition

o Price taking

o Product homogeneity

o Free entry and exit

▪ For all firms, competitive or not, profit is maximized when MC = MR

▪ For a firm in a perfectly competitive market, profit maximization occurs when MC = MR = P

▪ A competitive firm’s SR supply curve is the portion of the MC curve that lies above the minimum of the AVC curve

▪ Industry supply in the SR is the horizontal summation of the firms’ individual supply (MC) curves

▪ LR supply curve is horizontal for a competitive constant cost industry. For increasing/decreasing cost industries, the LR supply curve is sloped

Chapter 9 – The Analysis of Competitive Markets

▪ Deadweight loss – net loss of total (consumer plus producer) surplus

▪ Economic efficiency – the maximization of aggregate consumer and producer surplus

▪ The share of a tax borne by consumers depends on the shapes of the supply and demand curves and, in particular, on the relative Elasticities of supply and demand

Chapter 10 – Market Power: Monopoly and Monopsony

▪ For a monopolist, the MR curve is derived from the market demand curve

▪ Monopolist chooses output level where MR = MC

▪ A monopolist has no supply curve

▪ A multi-plant firm will choose output levels such that MC1 = MC2 . . . = MR

▪ Lerner Index of Monopoly Power (L) = (P – MC) / P

▪ The less elastic the firm’s demand curve, the more monopoly power it has

▪ Monopoly power depends on

o The elasticity of market demand

o The number of firms in the market

o The interaction of among the firms

▪ Monopoly power results in a deadweight loss

▪ Rent seeking – spending money in socially unproductive efforts to acquire, maintain or exercise monopoly power

▪ When a firm has monopoly power, price regulation can reduce or eliminate the deadweight loss

▪ A natural monopoly is a firm that can produce the entire output of the market at a cost lower that what it would be if there were several firms

▪ A monopsonist buys goods at the level where Marginal Expenditure (ME) is equal to Marginal Value (MV). For the monopsonist, the ME curve lies above the market supply curve

Chapter 11 – Pricing with Market Power

▪ Pricing strategies for firms with market power are tactics for capturing consumer surplus and transferring it to producers

▪ Price discrimination

o First degree – charging each consumer his reservation price (i.e. capturing 100% of consumer surplus by making the MR curve equal to the demand [AR] curve)

o Second degree – charging different unit prices for different quantities of a good

o Third degree – dividing consumers into several groups with separate demand curves (MR1 = MR2 = MC)

▪ Intertemporal price discrimination divides consumers into high and low demand groups

Chapter 12 – Monopolistic Competition and Oligopoly

▪ Monopolistic Competition

o Firms compete by selling differentiated products that are highly substitutable

o Free entry and exit

o In the LR, a firm’s demand curve will be tangent to its AC curve (and downward sloping) implying zero economic profit in the LR

o Two sources of inefficiency

▪ Deadweight loss

▪ Excess capacity since the firm’s demand curve does not intersect the AC curve at its minimum (as in Perfect Competition)

o Oligopoly

▪ Oligopolistic markets stabilize in Nash Equilibria where each firm is doing the best it can given what its competitors are doing

▪ Cournot model

• Firms compete via output levels simultaneously

• Reaction curves plot q1 vs. q2 for each firm where the curves chart the profit-maximizing level of output for one firm assuming a fixed level of output for the other

• Nash equilibrium is the intersection of their reaction curves

▪ Stackelberg Model

• Similar to Cournot insofar as firms compete on output

• One firm sets its own output first and the second firm has to react

• First-mover chooses output level on the second firm’s reaction curve that maximizes the first firm’s profit

• First-mover advantage

Chapter 16 – General Equilibrium and Economic Efficiency

▪ An allocation of goods is efficient only if the goods are distributed so that the MRS between any pair of goods is the same for all consumers (otherwise, they could be made better off by trading)

▪ See page 606-7 for summary of efficiency

▪ Reasons for market failure

o Market power

o Incomplete information

o Externalities

o Public goods

Chapter 18 – Externalities and Public Goods

▪ An externality occurs when a producer or consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market

▪ For a negative externality, the efficient level of output is found by adding the Marginal External Cost (MEC) to the firm or market’s MC or supply curve to obtain the Marginal Social Cost curve. The intersection of the MSC and the demand curve provides the efficient level of output

▪ In the case of a positive externality, add the Marginal External Benefit to the demand curve to find the Marginal Social Benefit curve

▪ Ways of correcting market failures

o Emissions fees

o Emissions standards

o Tradable emissions permits

▪ Demand curve for a public good is the vertical summation of individuals’ demand curves

▪ The free-rider problem makes it difficult or impossible for markets to efficiently provide public goods

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